The correction we had to have

International equities have not been a pretty sight for the first six months of this year.

Even emerging markets, which were supposed to be immune from any downturns, fell with the more traditional markets.

The US sub-prime mortgage crisis was the popular culprit for the fall, but there were other factors making a correction inevitable, according to BNY Mellon — The Boston Company chief investment officer John Truschel.

“The market was overheated in the spring of last year and the fall wasn’t just due to the sub-prime crisis,” he told Money Management.

“It was looking stretched in earnings expectations and needed some correction to the valuations.”

“Perhaps two-thirds of the reasons why markets fell was due to sub-prime, but if it hadn’t, there would have been some other weakness that would have caused the fall.”

Falkiner Global Investors chief executive officer James Falkiner believes international markets have been through a typical slowdown in a normal economic cycle.

“I see what we have been through as a typical mid-cycle economic slowdown,” he said.

“The Fed’s monetary policy has engineered a mid-cycle slowdown to deliver a soft landing.”

Falkiner said the handling of the sub-prime crisis by central banks has prevented a large market bubble forming.

“People will criticise central banks for putting rates up, but it [was] a strong financial solution,” he said.

Commenting on the downturn, Vanguard Investments Australia chief investment officer Eric Smith pointed out the better recent performance of currency hedged international funds compared to their unhedged counterparts.

According to Vanguard, its unhedged international equity fund was down 11.0 per cent for the past six months — in line with its Australian equity fund down 11.6 per cent — but its currency hedged international fund was only down 4.1 per cent.

Smith said the figures showed the importance of understanding the impact currency movements can have when comparing market performances.

“Hedged international funds remove the impact of currency, exposing the underlying market performance. In the last six months, international equity markets have fared significantly better than the Australian market, offset by the strengthening Australian dollar for investors without currency hedging,” he said.

In terms of stock selection, Invesco Quantitative Strategies head of client portfolio management Michael Fraikin said the US slowdown has affected many stocks, with the exception of those companies connected to the resources boom.

“The US slowdown has impacted the market severely,” he said.

“It was also disappointing that emerging markets didn’t escape.”

The US slowdown has now spread to the UK and Europe, but some countries are performing better than others, he said.

“Germany as an economy is doing well, probably because it exports significant amounts of machinery that is in demand for the resources boom,” he said.

“Its earnings have benefited from having an industrial manufacturing base.”

On the other hand, Spain, which relies on agriculture, tourism and financial services, has suffered a sharp slowdown, he said.

“The countries that are doing well have big companies in utilities and oil. However, France has budgetary problems, so it is also suffering a slowdown.

“Italy would have similar problems.”

Fraikin added that another factor affecting the European slowdown and falls in productivity is the ageing populations of some countries.

“It is the demographics of some countries that are delivering differing economic performance in Europe,” he said.

“It is hard to say there is a broad slowdown in Europe, as some countries are doing better than others.”


International fund managers are more optimistic for the future of the sector, although most accept there is still some problems to come.

However, the bad news that has caused the dramatic volatility in the past six months could almost be over, Truschel believes.

“What the Fed and all central banks did in February helped the healing process and stopped it getting worse,” he said.

But Truschel accepts the knock-on effect of the sub-prime crisis is still occurring in non-financial industries.

“The effect on consumers is being filtered down into the system, as big financial services companies’ earnings power has been severely diminished,” he said.

“There probably will be some more bad news to come, but that doesn’t mean the markets are going to suffer.

“But we should be thinking about what markets are going to be doing in the next 18 to 36 months, not the next 12 months.”

Fraikin, who maintains a positive outlook, said in mid-March the markets were looking into the abyss, but opportunities in international markets are starting to appear.

Falkiner expanded on this, saying markets have bottomed, the US dollar has been downgraded dramatically and the US long bond has rallied.

These actions will have a stimulatory effect on the future of international markets, he said.

“We are not looking at a Japanese scenario of the early 90s, where markets kept falling.

“We think it is a good time to go into international as the markets are at the bottom.”

While people have been focusing on the economic outlook, Smith said markets are more forward looking and are a good indication of where the sector is heading.

“We are strong advocates of looking at overall markets for directions,’ he said.

“They have been highly volatile, but there is light at the end of the tunnel.”

Based on the probability of what could happen in markets, Smith said there was a 75 per cent chance that by the end of the year they will be delivering positive returns.

“We don’t think it is all doom and gloom for the future,” he said.

“We are still convinced a client needs exposure to international funds for diversification.”

Vanguard has increased the international weightings in its diversified funds to 50 per cent and is increasing its exposure to global small caps.

“We think this is an allocation that stands the test of time,” Smith said.

But problems with global markets are not over yet.

While attention has started to move away from sub-prime, the new cloud on the horizon is oil, but some managers don’t see it as a problem.

Truschel said high oil prices are due to supply and demand reasons and that will keep prices high for some time.

“The credit crisis has come and gone, but the real question is how to read the emerging BRIC (Brazil, Russia, India and China) economies,” he said.

Therefore Truschel said opportunity in international investment lies where population continues to grow and the demographics of this expansion.

However, Falkiner is bullish about future returns in the international sector and is willing to predict a very positive result of 15 per cent across global equity markets during the next six months.

His reasoning is the role the Fed played during the 1998 credit crunch, where US stocks fell 50 per cent.

“In both 1998 and 2007 the US Fed was attempting to engineer a mid-cycle slowdown and had already hiked rates in response to earlier inflationary pressures,” he said.

“The resultant fallout was primarily driven by credit markets.”

Falkiner said there were parallels between the 1998 crisis and today, where markets fell and the Fed cut interest rates.

“From its October 1998 lows, the market rallied to the previous high in less than two months,” he said.

“This time the market has recovered 8 per cent to date, and we expect further gains.”

In 1998 the market recovered its previous high and then added a further 27 per cent, Falkiner said, arguing that a similar scenario was about to unfold.



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